What’s an interest rate?
An interest rate is an amount that is charged on top of the principal or primary amount you’re offered as a loan. It also applies to the amount earned at a bank or credit union from a savings account. Interest rate is calculated as an annual percentage rate, and the payment could be fixed or variable.
What should you consider before taking up a loan?
Some of the key points to consider about interest rates include:
- You and the lender work out the interest by the set loan terms.
- The interest is payable on top of the principal amount you borrow.
- Bank rates dictate interest on loans.
- Defaulting or late payments on a loan increases your interest rates.
As a borrower, you’ll be confronted with different, if not multiple, forms of interest. Knowing the type of interest rate and its impact is crucial in loan acquisition. This information could help you leverage a better deal on your loan.
Types of interests
Below are the types of interest you may come across:
Fixed interest
This is probably one of the most common forms of interest rates for consumers. It’s a specific, fixed interest tied along a loan to be repaid with the principal.
Variable interest
Unlike fixed interest, a variable interest rate changes according to changes in market interest rates. It is pegged on a reference rate such as federal funds rate or London Interbank offered Rate (LIBOR)
Annual percentage rate
This is the amount of your total interest expressed annually on the total cost of the loan. It’s mostly used by credit card companies when consumers agree to carry a balance on their credit card accounts.
Prime rate
Banks have special interest rates they give some of their favoured customers. i.e., when Banks borrow between themselves. These rates are usually lower than the usual ones.
Discount rate
This rate is usually given to financial institutions for short periods. It’s a rate not for the general public. Banks use discount rates to cover daily funding shortages, correct liquidity issues, and keep the bank afloat when in crisis.
Simple and compound interest
Simple interest is interest calculated on the principal portion of a loan, while compound interest is the addition of interest to the principal sum.
Loans have become a vital part of our financial journey. Whether it’s for a roof over your head or a business investment, understanding what you are paying back could help you make better decisions and perhaps save a coin or two.
Sources: Young Mogul, Investopedia, The Street, Corporate Finance Institute, Bank Rate
